10 things about RBI's latest move to defend the rupee

The Reserve Bank of India announced several steps to stop the slide in the Indian rupee on Monday, which hit a record low of 61.21 last week. The falling rupee not only poses big challenges to the economy, it's also likely to become a political issue for the government seeking to win a third straight mandate early next year.

The Reserve Bank of India announced several steps to stop the slide in the Indian rupee on Monday, which hit a record low of 61.21 last week. The falling rupee not only poses big challenges to the economy, it's also likely to become a political issue for the government seeking to win a third straight mandate early next year.

Here's what the RBI has done and how experts' view these moves

The RBI has increased the Marginal Standing Facility (rate at which banks borrow from the RBI using their statutory liquidity ratio securities as collateral) rate. So far, banks (bearish on the rupee) borrowed from call money markets and bought dollars in the forward markets expecting the dollar to rise. Since, borrowing short term money will now be costlier, banks will most likely cut their forward positions and reduce speculative trading. This will reduce pressure on the rupee.

The RBI has capped the amount banks can borrow from overnight markets to Rs 75,000 crore. The RBI will also conduct Open Market Sales of bonds of Rs. 12,000 crore on Thursday. These measures are aimed to suck liquidity from the system. Bond prices will fall and yields will rise. Higher yields will attract foreign investment back into the debt market at a time when FIIs have sold billions of dollars ever since the U.S. Fed signalled a tapering of the quantitative easing.

The new steps were announced after RBI's earlier steps to sell dollars in forex markets through state-run banks failed to halt the slide in the currency. Moves taken to curb speculative trading last week helped the rupee snap a nine-week losing streak, but the currency slipped below the psychological 60 mark again on Monday, necessitating more steps.

The Indian rupee jumped over 1 per cent to 59.13 in early trades on RBI measures. Sonal Varma of Nomura said the measures are "a classic textbook response". These steps will tighten domestic liquidity, raise short-term interest rates, increase the relative interest rate differential and possibly stem debt outflows, Ms Varma wrote in a note.

But stock markets fell, with the Sensex plunging 385 points in early trades fearing there will be no rate cut later this month. Finance Minister P Chidambaram tried to calm markets. He said RBI measures were aimed to quell speculation and volatility in forex markets. "These measures should not be read as a prelude to a policy rate changes," he added.

Analysts said the probability of a rate hike, if today's measures are not successful in stemming rupee depreciation, has gone up. Nomura said there is a risk that today's measures could backfire. "India's growth is already very weak and tighter domestic liquidity will worsen the financial conditions for corporates and banks, hurting asset quality and the growth outlook," the investment bank said.

There are fears that current moves may succeed in stemming debt outflows (helping the rupee), but growth-sensitive equity flows will be at risk. So, stock markets will fall further, with banking stocks at the highest risk. Barclays said if the higher rates were to persist and impact GDP growth then that would impact the entire banking system negatively. The Bank Nifty slumped over 4.5 per cent lower, underperforming the the broader Nifty.

This move will impact the banks and NBFCs in two ways. One, directly through net interest margins (which will fall) and two, indirectly through the impact on GDP growth, Barclays said. Yes Bank traded with over 8 per cent cut, while IndusInd Bank shares shed 7 per cent.

These measures are unlikely to send the rupee in a permanent upward trajectory. The government needs to address fundamental problems such as high current account deficit, analysts said. Prime Minister Manmohan Singh will discuss a proposal to increase Foreign Direct Investment (FDI) cap in sectors like telecom, retail and defence later today. Liberalizing FDI rules will help attract foreign investment into the country, which is badly needed at a time when the rupee is the worst performing currency in Asia.